Wednesday, July 29, 2009

Mellow Out Your Portfolio As You Grow Older

One lesson from the recent stock market crash is that you should reduce your portfolio's risk levels as you grow older. In particular, if you're retired, you should moderate your exposure to potentially volatile assets like common stocks, commodities and long term bonds. When the markets for these assets turn down (and market downturns are inevitable, something we now know quite well), you'll have less time to recover your losses. Thus, gradually reducing your exposure to bouncy assets provides greater stability to your portfolio's value and better quality sleep.

The importance of portfolio stability can be seen in the ongoing controversy over target date retirement funds. These funds supposedly diversify your savings for you, and change the allocation as you grow older to protect an increasing portion of your gains. However, some target date funds for those already retired seem to have suffered losses in the range of 25% during the stock market crash. That would imply that they had half to two thirds of their assets in stocks.

Was it wrong for these target date funds to allocate so much of their portfolios to stocks when they were meant for investors already in retirement? It depends on how you look at things. Many financial planners tell you to prepare for a 30-year retirement. This is because a healthy 65-year old has about a 25% chance of reaching age 90. And some nonagenarians will chug along for years. It's tough to run out of money when you're, say, 93, because few people at that age can work. So, one school of thought is that you should keep a pretty large percentage of your portfolio in stocks to capture 30 years of gains in case those gains are needed.

Planning for the long, long term in this way leaves you exposed to shorter term risks, such as today's financial mess. Most people won't live 90 or 95 years. The majority of 65 year olds will be gone by age 85. Planning for a 20-year retirement might make more sense for most retirees. Of course, if you come from a family with longevity, you would be well-advised to think in terms of 30 years.

A fairly well-known rule of thumb is that your age specifies the percentage of your assets that should be in stable investments. In other words, if you're 65, then approximately 65% of your assets should be in cash and a diversified portfolio of bonds and/or a laddered set of CDs. The remaining 35% could be in stocks, with perhaps a small proportion in commodities (such as 5% or less). If you're 80, then 80% of your assets would go into cash, bonds and CDs. The rest would be invested in stocks. This is a highly conservative approach and leaves the retired and elderly largely out of stock market gains (such as this year's surge from March to July). But if you want to be cautious, then follow this rule of thumb.

Whatever you choose, remember that you're making a choice. A conservative portfolio means getting a relatively small boost from stock market gains. But you'll see less shrinkage of your portfolio in bad times. A more aggressive portfolio may be better if you live a long time. But you should be prepared for volatility, and the need to cut back on spending during down times. The target date funds with large losses didn't make a mistake by having a large stock component for their portfolios. They made a choice, one that perhaps not all of their investors understood. Their mistake, if any, was in not clearly explaining to investors what risks they were taking. Perhaps these funds should have suggested that skittish investors put at least some of their money in a more conservative investment. A target date fund may be a good choice for those that don't want to devote a lot of time to money management, rebalancing portfolios, and altering asset mixes as one progresses through the years. Just remember that it, like all investments, will have good days and bad days.

If you don't have confidence in target date funds, then allocate your savings among cash, bonds, CDs and low cost index funds, in whatever proportion makes you comfortable. There's nothing wrong with 100% cash. It's just another choice. Just remember that it gives you little protection against inflation and no participation in stock market gains. If you can live with that, make sure the cash goes into FDIC guaranteed accounts, and best of luck to you.

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